Development Magazine Summer 2016

Finance

CRE Lending Environment Tightening

The commercial real estate lending market is in a period of adjustment, as lenders adapt to a shifting economic and regulatory landscape.

AS 2016 BEGAN, lenders became increasingly cautious in reaction to worrying economic news, including volatility in the stock and energy markets, deteriorating conditions in the global economy, and a slowdown in the U.S. economy. K.C. Conway, senior vice president of credit risk management and senior valuation officer at SunTrust Bank, describes the atmosphere: “The mood that I’m sensing is that the market is holding up, but there is a lot more anxiety now than there was in Q4 2015.” Conway adds that the Federal Reserve interest rate increase in December also contributed to lenders’ growing unease.

HVCRE Impacts

In addition to shifting economic conditions, the commercial real estate lending market is also facing changes in the regulatory environment. In early 2015, the Basel III regulation regarding high volatility commercial real estate (HVCRE) took effect for most banks. The regulation requires banks with over $500 million in assets, as well as all savings and loans institutions, to set aside increased capital against certain construction and development loans. (For more on the Basel III regulations, see “Banking Regulations Could Mean Trouble for Construction Financing.”)

Conway explains: “As a bank, we have to reserve 150 percent of our normal capital for an HVCRE loan. So, the pricing gets materially more expensive for a construction loan. The cost and documentation involved with an HVCRE loan make it both more difficult and more costly to make a construction loan. Banks are going to have to charge a higher rate. They are trying to figure out if they want to [make] construction loans and if they have priced them competitively.” Consequently, the terms banks are offering on construction and development loans are tightening. Conway notes that banks are now underwriting to current rental rates instead of to pro forma with projected rent growth. Going-in loan-to-value (LTV) ratios are also getting more conservative, dropping from 75 to 80 percent to under 70 percent.

David Kessler, a partner and national director of commercial real estate at CohnReznick, points out that increased regulation like HVCRE is causing banks to “cherry pick and do loans with people that they know, trust and have done business with before, versus the newer start-ups who may be just as good but don’t have the history.” As banks pull back from some construction lending, Kessler observes that unregulated lenders such as pension and private equity funds and life insurance companies — sometimes referred to as “shadow bankers” — are coming in to fill that gap often at a higher cost. According to Kessler, borrowers “are going to these alternative sources of capital because they need the execution. They don’t have time to go through the underwriting process.”

Risk Retention

Another regulation that will affect commercial real estate lending, the risk retention rule, will go into effect in December 2016. It implements the risk retention requirements in the Dodd-Frank Act and applies only to the commercial mortgage-backed securities (CMBS) market.

Kessler explains the new regulation and its implications “Risk retention will require that the originator retain 5 percent of every new deal or designate a B-piece buyer to take on the risk. That is going to drive up rates. The projection is that the costs are going to go up and there will be a decrease in the amount of originations.” Kessler also expects the number of CMBS issuers to decline. “Twelve of the largest banks did 90 percent of the CMBS volume four years ago, and now they’re doing 65 percent of the volume. Smaller boutique shops have been getting into the CMBS business, filling the void of the larger banks, and now regulations are going to kick in that will probably drive them out.”

The murky economic outlook and new regulatory requirements will influence the cost and availability of debt in the commercial real estate market. Nonetheless, 2016 is expected to be an active year for CRE lending. The Mortgage Bankers Association predicts that commercial and multifamily originations will rise 3 percent over 2015 totals, potentially outpacing the previous record set in 2007. Conway believes that volume will be buoyed by borrowers trying to lock in low interest rates. He observes, “$100 billion per year of commercial real estate loans made at the height of the market from 2006 to 2008 in the CMBS space are coming due from 2016 to 2018.” Savvy borrowers will be trying to refinance these loans now.

Lenders are expected to be increasingly focused and disciplined, given the economic and regulatory environment they are facing. Kevin Jennings, Southern California market executive for Bank of America Merrill Lynch, comments, “Given all the volatility that has been taking place in the general market as well as in the CMBS market, there is going to be a flight to quality. Lenders have narrowed their focus and are looking to quality assets and quality sponsors.”

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